Rationale For Diversification

Below is a rationale for diversification presented by ShareBuilder on their website. It is reproduced here because it does a good job of explaining the rationale behind the conventional wisdom of diversification – which The Plan completely debunks.

Allocating Your Assets

Asset Allocation is the strategy of dividing your investments among stocks, bonds, cash, and other investments. It can have a major impact on reaching your financial goals. Here’s why:

No single asset class has the best return year in and year out.

Stocks historically have the highest returns in most years and in the long term, but they’ve also had major losses in some years, or have just been flat in others.

Bonds have had the highest returns in some years, but have had losses in others.

Cash usually has the smallest returns (often not even matching inflation), but it’s rare that you’ll actually lose principal.

When we’re talking about Asset Allocation and we say “stock and bonds,” we’re also including mutual funds and exchange-traded funds (ETFs) that hold those securities. Cash could be invested in certificates of deposit (CDs), US Treasury bills, or money market funds.

Choosing an Allocation

When you set out to choose an asset allocation that works for you, consider your goals, your age, and your tolerance for risk.

Goals matter. You’re investing so that you can reach your financial goals!

Age matters because it may influence the level of risk you can take. The younger you are, the more time you may have to overcome short-term losses. That often means investing in more stock and stock funds.

Risk tolerance is a measure of how big of a drop in your portfolio’s value you can stomach before selling off your holdings in a panic.

Market Cycles

Ups and downs in a single asset class often occur at different times than in other asset classes. For example, when interest rates are high, bonds and cash tend to do better than stocks. But when corporate earnings boost stocks, bond returns may be flat or falling.

In a perfect world, you’d have all of your investments in the asset class that’s performing the best, but it’s impossible to predict that correctly all of the time. The reality is that market cycles happen, but knowing the timing of these cycles is nearly impossible.

An alternative to guessing the timing on market cycles is to own some assets in each class all of the time. That way, you’ll always be invested in the best-performing class, whatever it happens to be. That puts you in a position to profit from any gains, which could offset losses in another class. Of course, asset allocation does not guarantee profits or protect against losses.

Managing an Allocation

Let’s look at an example. Say you’ve divided your $10,000 portfolio into a 60% stock, 30% bond, and 10% cash allocation. Each time you have money to invest – say $1000 – you put $600 into stocks (or stock funds), $300 into a bond fund, and $100 into a money market fund.

If the stock market booms and the bond market falters, you may end up with a portfolio that has 75% stocks, 20% bonds, and 5% cash. Ultimately, that means you’re exposed to more risk, and your current allocation may be out of sync with your investment goals.

If you’re committed to the allocation you’ve chosen, you could sell some of your stocks and use the proceeds to buy more debt securities to return to your original balance. Or, a potentially easier strategy is to stop putting new money into stocks for a while and concentrate your investments on the other asset classes until you’re closer to your original allocation.

It might seem smart to invest more in stocks or in bonds while they’re hot, doing so may increase your risk by tampering with the allocation you’ve chosen, and you might not come out ahead in the long run. Asset allocation is all about investing with your head, not your heart.

Into the Future

Asset allocation is a strategy that can be used for your taxable accounts and for your retirement nest egg. That may mean putting part of your 401k or your IRA into stocks and some into fixed-income investments.

It might make sense to look at your bigger financial picture to include both your taxable and your tax-advantaged accounts. For example, if you’re focusing on growth in your 401k account, you may want to put a larger share of your taxable account into dividend-paying stocks and the funds that invest in them.

Sorting out all the details and figuring out the best overall allocation has the potential to make a real difference to your bottom line.